DEALMAKER GUEST BLOG -- JOSEPH W. BAUER

Evaluating insurance before a deal closes can mean big savings right away

Blog Entry: September 04, 2013 4:30 AM | Author: JOSEPH W. BAUER

Joseph W. Bauer served as Lubrizol Corp.'s chief legal officer for 20 years prior to its acquisition by Warren Buffet's Berkshire Hathaway Inc. Now he is the principal of Bauer Advising LLC, a consulting firm to companies and law firms on matters of commercial insurance and legal fees.

For most companies — even small and middle market ones — the business insurance portfolio represents a significant cost. Especially for companies with substantial manufacturing equipment, the “all in” cost of the enterprise's commercial insurance will normally be five to 10 times the cost of all outside accounting and finance services, and often will exceed all legal expenses.

But in the deal process, the quality and cost of the acquired company's business insurance rarely receives a disciplined and independent assessment.

Even sophisticated buyers normally perform only a rough-and-ready assessment of a targeted company's commercial insurance arrangements in the diligence process leading up to closing. Most of the time, they are missing a chance to reduce operating costs on day one of their new ownership, and the cost reductions could be material.

Dealmakers and their counsel would serve their clients well by making sure that a studied analysis is conducted and discussed in detail before closing with capable brokers and product specialists, including the target's incumbent broker and an independent adviser. By rightsizing the insurance in place to meet the risk appetite of the new owner, and by taking a fresh look at the appropriateness of data driving premiums, savings generally will be in six figures for smaller companies, and often will reach seven figures for larger targets.

Here's why and how:

What usually happens in due diligence

The usual approach to insurance diligence is the compilation of a list of the various policies in place, accompanied by a summary of the most essential information from the policy declarations. This is normally prepared by the seller's broker or the buyer's broker (who may be the same), and is then reviewed by buyer's counsel.

The going-in assumption is that “insurance pretty much takes care of itself.” Nothing approaching the buyer's financial analysis to scrub the quality of revenues or earnings is conducted. Questions central to the appropriateness of the target's insurance — and its cost — are usually not asked. And if they are, the answers are rarely independently tested.

Two examples of frequently overlooked opportunities

What, specifically, will a fresh look at the target's insurance purchases produce? The likely opportunities for cost reduction and coverage improvement are numerous, but here are two areas that in our work almost always result in revised approaches at materially less expense.

For most companies, the property insurance program will be the most costly, usually accounting for at least half of consolidated insurance premiums. The premium charged for this coverage is computed from a base comprised of two sets of estimated values submitted by the target company.

One set is the estimated cost to replace buildings, plant and equipment at each of the company's sites. The second set, known as the “business interruption” or “time element loss,” is the estimate of lost gross profits for each site, assuming a hypothetical disablement of that site for a stipulated twelve-month period. The sum of these two sets of values constitutes the “total insured value” against which the premium is computed.

An example: If the estimated cost of replacing all of the company's property and equipment is $500 million, and the total of all estimated business interruption loss is $500 million, the total insured value is $1 billion. If the insurance company has quoted a rate of 12 cents per dollar of insured estimated values, the annual premium will be $1.2 million.

We consistently find that companies, large and small, tend to overestimate the amount of business interruption loss that will occur at many of their sites. It is not uncommon to find an estimate for a small manufacturing location equal to many times the historical annual EBITDA (earnings before interest, taxes, depreciation and amortization) for that site, or for a sales office to be listed with significant estimated profit loss. When this happens, premium is being paid for loss that can never be payable under the policy. In the example above, if the combined business interruption loss has been overestimated by $200 million, the target is paying $240,000 more in premium than it should be, assuming the quoted rate is appropriate.

2) Liability insurance disconnects with target's loss history and the nature of its business.

The selection of liability insurance is normally driven by the risk appetite of the company purchasing it and the broker's success in recommending specialty policies. More attention should be paid to the actual paid loss history of the target under the coverage in place. Nothing else is as telling as to the appropriateness of the liability policies.

One good example is coverage known as “employment practices liability” (EPL) insurance. Many companies, perhaps even your target, have purchased it, especially in recent years. This coverage can add value to companies with large employment forces but very small legal departments. The policy acts more like a claims handling mechanism than as true risk transfer insurance. In our reviews for companies, we usually find that these policies rarely produce a paid claim, because the self-insured retention (including for legal fees) is normally much higher than any historical paid claim, and the claims that present high cost exposures (such as claims under the Fair Labor Standards Act) are expressly excluded altogether. If paid claims over the past five years reflect less than 125% of the aggregate premium over that period (and you will find they often reflect 0 to 10%), you are looking at the opportunity to send real money directly to the bottom line.

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